Index funds are a fantastic invention for a number of reasons. But a couple of years ago, I wasn’t all that keen on investing in Australian index funds, as I wrote about here.
Yet fast forward to today, and the Vanguard Australian shares index fund (VAS) is one of the biggest holdings in our portfolio.
What’s up with that? Well, my thinking has been evolving over the last couple of years. So today I’ll talk about what I’ve learned and why my view has changed.
A disclaimer. I’m no expert investor or finance professional. In fact, I’m probably more of a novice than many of you realise!
My thoughts will continue to evolve as my experience grows and I (hopefully) learn more over time. So as always, none of this is investment advice and don’t just take the info on this blog (or any other blog for that matter) as gospel.
And of course, do your own research and decide what’s right for you, before making investment decisions. Okay, let’s move on…
Why did we buy an index fund?
As of last year, we started buying shares in an Aussie index fund. In case you missed it, I went into some detail about it in our Investment Portfolio Update.
Basically, as the market was falling toward the end of 2018, the LICs we own barely fell at all. Because this is a common occurrence (LICs regularly trade at premiums or discounts), and since I wanted to take advantage of lower share prices and higher dividend yields, I decided to add an index fund to our portfolio.
This way, it gives us more opportunity to buy shares at attractive prices, versus holding LICs only. That was the primary reason, but it was also on my mind for other reasons. Let’s look at those now.
The index is more diversified than before
The Aussie sharemarket gets a bad rap sometimes for being pretty concentrated. And to some extent, that’s fair. It was only a few years ago that over 40% of the ASX300 index was in the Financials sector.
On this site – www.asx300list.com – you can find archived information on the index (down the page) if you’re interested. Anyway, today Financials are about 30% of the ASX300.
Traditionally, some older LICs like Argo have made an effort to avoid being too exposed to one sector of the economy. And when you have a Financials sector at over 40% of the market, getting more sector diversification is naturally appealing to some.
So sector diversification has improved in recent years. This has happened for a couple of reasons. The banks have struggled due to the Royal Commission, slowing growth rates for mortgage lending and margins being squeezed.
With commodity prices rebounding, mining companies have been raking in cash, so their market values have increased. But we also have a number of mid-sized companies growing strongly, which are climbing up in the index – a number of which have global operations.
But regardless of the reasons, I personally feel more comfortable with a sharemarket index that is less reliant on one particular sector. And I expect the Aussie index to become more diverse over the next couple of decades, which I’ll go into in the next post!
Market returns are driven by a handful of stocks
Every now and then I learn something that blows my mind. The ‘positive skew’ of sharemarket returns is one of those things. And actually, this factor, more than any other, convinced me of the power of index funds.
Nicely summed up by Michael Batnick in this post called “The Skew”:
“No, it’s not just the fees or the competition, but rather, the simple reason why so many managers fail to beat the benchmark is because so many stocks fail to beat the benchmark. The biggest winners have an outsized impact on the index, and there is a steep price to pay for missing them.”
In the post, Michael shares a study done from 1994-2016…
It shows the performance of the US sharemarket over that time was 7.3% per annum. But if you had missed the top 10% performing stocks each year, your return would drop to 2.9% per annum. And if you missed the top 25% performing stocks, your return would be -5.2% per year.
How about that skew…
Another great example of this factor is this post from A Wealth of Common Sense, by Ben Carlson. Ben shows research from Longboard Funds using data from 1989-2015, with the following findings on individual stock performance.
What does this mean?
Well, all of the gains in the S&P 500 came from the 20% best performing stocks. Incredible! Not only that, but 40% of all stocks during the period actually had a negative return.
Now, we don’t know if this is always the case. Or if this factor is the same with Australian companies. But I think it’s likely to be an ongoing factor of markets and is a similar story in many countries. I’d love to see a study on this in Australia.
Essentially, this is like the Pareto Principle, or the 80/20 rule in practice.
The market’s long term returns are often driven by a small group of companies which are huge winners. And since it’s not obvious which companies it’s going to be, buying the whole market (an index fund) is the easiest way to benefit. That way, you’re guaranteed to capture the outsized returns (including dividends) from the big winners.
After learning about this ‘skew’ factor, the idea of owning every major company made a lot more sense. I’m not sure why this isn’t spoken about more often. And it also helps explain the difficulty in beating the market for individuals and professionals alike.
Consider that for a moment. Active managers are not dumb people. And most of the time they’re probably quite intelligent business analysts and stock pickers. But if they simply miss a couple of huge winners, they’re going to underperform.
An income-focused investor may also miss out on the best dividend growth stocks because they (or their active manager) were too cautious to buy the stock. Maybe it looked expensive or they were concerned about the industry etc.
Let’s say there’s 300 stocks in the market, and you own 200 of them. While your results may mirror the market much of the time, if the best companies turn out to be in the 100 you’re not holding, you’ll underperform.
Strange as it sounds, better returns may be had by holding a larger number of stocks. Usually the opposite is thought to be true. Of course it’s possible to outperform with a concentrated portfolio, it’s just hard. But by holding more companies in your portfolio, you’re more likely to be holding the future big winners.
It sounds very unsophisticated, even amateurish. But it makes sense. While many quality companies have things in common, it’s just not that easy to pick the future outperformers in advance. Otherwise we’d all do it and become rich. But that can’t happen.
Someone has to be holding the losing stocks. And they’re holding because they think it’s going to do well in the future, or it’s undervalued, or whatever.
Other features of index funds
Despite the above being a major reason that convinced me to add index funds to our portfolio, there are positives.
The next most attractive thing for me is simplicity. Having one holding which owns the market and knowing you can hold it forever is a pretty powerful concept. There is no active manager risk, or decision-making required.
Owning an index fund today which holds the top 300 Australian companies is nice. But by owning the index for the next 50 years, you’re also guaranteed to own the top 300 companies in 2069, whatever they are… (space mining, alien communications, multi-planetary transport, time-travel companies?). That’s even cooler!
This is because index funds are self-cleansing. The index will simply hold the largest companies by market value all the time. As companies grow and shrink, they rise and fall in the top 300. As time goes on, some of the losing stocks on this list are removed as they fall out of the top 300, and they’re replaced with new, growing companies.
Also, like the old LICs discussed here many times, broad market index funds are low cost and low turnover. This makes them tax efficient.
Why did we choose Vanguard?
I’ve answered this question before, but I’ll share this again for those who missed it. There are a number of perfectly fine index funds out there from reputable providers. But I chose Vanguard’s ASX300 index fund – VAS – for the following reasons.
1– The other Aussie index funds track the ASX200, whereas Vanguard tracks the ASX300. Those extra 100 companies are only a small percentage of the fund today. But as the economy grows and broadens over the next few decades, I’d expect (and hope) those extra 100 companies become more important and a greater weighting in the index than they are now. And if I’m going to buy an index, I might as well buy the broadest index available.
2– Although there is a slightly cheaper option available, I’m happy to pay slightly more for Vanguard’s reputation of driving costs lower and putting investors first. Most index fund providers are profit-motivated, whereas the parent company Vanguard US is essentially a not-for-profit company (by that I mean all profits are returned back to investors in the form of lower costs).
So although Vanguard Australia isn’t the same as this, the fees are still flowing back to the ‘not-for-profit’ Vanguard US. Besides, I fully expect Vanguard and other broad index funds to end up at basically zero fees sometime in the next decade or so anyway (already happening in the US).
3– Vanguard have a proven track record of indexing over many decades – longer than other index fund providers.
4– VAS is a very large and established index fund, with the highest liquidity, meaning no issues buying or selling. See an index ETF comparison here.
5– VAS has also started doing securities lending (which is letting traders borrow stock to sell – a very common practice that many index managers in the US do as well). This helps the fund earn a little bit of extra income and could result in slightly higher returns (or lower net costs) going forward.
These are the reasons I chose VAS. But to be clear, there is nothing wrong with the other low-cost index options in Australia!
Why hold both LICs and an index fund?
Well, it’s a fair question. I like both investments. And for now, I feel comfortable investing in each. They both have attributes I like.
The old LICs are much more likely to provide a dependable, steadily growing income stream over time, and they are managed with a focus on fundamentals (earnings and dividends). The human element can be a positive in ensuring the portfolio will always be full of dividend-paying companies and avoiding some of the speculative nature of sharemarkets, by avoiding hyped-up shares with no earnings.
LICs can also trade at premiums and discounts, and given these vehicles are mostly owned by retail investors (not professionals), it can offer some attractive buying opportunities. I don’t believe share prices of LICs are as ‘efficient’ as some assume.
Having said that, the index is statistically likely to provide a higher long term return. The no-human element can be a positive in ensuring there are no poor investment decisions made and owning the whole market means being guaranteed to hold the long-term winners.
The index would also fare marginally better for low bracket taxpayers, should franking credit refunds be altered with, as I spoke about here. Also, it always trades at NTA so there is no chance of overpaying. Lastly, it’s very simple to understand and can be confidently held forever.
In short, investing for a reliable and growing dividend income stream is very important to us. But after learning more, these days I have a greater respect for index funds. So by owning both, I capture the ‘skew’ factor and have more chance to buy shares at attractive prices, like my example of late last year.
Index funds and LICs are not opposites, and they’re not enemies. One will track the market and own everything. The other owns a portfolio to provide a growing income to shareholders and probably hopes to do a bit better than the market over time.
But they’re both a low-cost, low turnover, tax efficient way of investing in a diversified portfolio of Australian shares for the long term. They both meet my personal needs and are what I’m happy investing in currently.
Remember, there is no perfect way to invest. You have to invest in a way that feels right for you! Speaking of which…
Do you own index funds? How do they fit in your portfolio? Share your thoughts in the comments.
By the way, I created an easy-to-use Dividend Tracker, which I use to keep a running estimate of our annual passive income after every purchase. Click here to get it for yourself.